Proof of Importance in Cryptocurrency
In the previous articles, we studied proof of work as well as proof of stake. We learned that the proof of stake mechanism was created in order to overcome the shortcomings of the proof of work mechanism. However, proof of stake itself has several shortcomings which have become increasingly visible over the years. In order to overcome those shortcomings, another mechanism called the proof of importance has also been created.
Proof of importance has been introduced by a cryptocurrency called NEM which is relatively obscure when compared to Bitcoin or Ethereum. However, since the mechanism has several advantages, it is becoming increasingly popular in the cryptocurrency market. In this article, we will have a closer look at the proof of importance concept and understand its advantages.
Shortcomings of Proof of Stake Mechanism
The proof of importance mechanism has been created in order to overcome the shortcomings of proof of stake. Hence, in order to understand proof of importance, we first need to understand the shortcomings of proof of stake. The three major shortcomings have been listed below:
- Firstly, proof of stake favors people who hoard the cryptocurrency. This is a self-limiting mechanism since the purpose of a cryptocurrency is to replace actual currency. Hence, cryptocurrencies should be incentivizing usage. Instead, cryptocurrencies that follow the proof of stake mechanism actually reward people for holding large amounts of cryptocurrencies in their wallets.
- Secondly, proof of stake favors the rich investors. People who have spare money to keep coins lying around in their accounts are more likely to get the opportunity to forge a block. Theoretically, if a person could own 10% of all the cryptocurrency blocks in existence, they could get the opportunity to forge 10% of all transactions and would therefore obtain transaction fees.
- Proof of stake rewards investors who hold the cryptocurrency in their account for short periods of time. The amount of cryptocurrency present in the wallet when the forging is about to take place is the only thing that matters. The amount of time it has been held has no relation to the decision being made by the network. Hence, proof of stake rewards investors to constantly trade in and out of cryptocurrencies.
The main purpose of the proof of importance mechanism is to overcome these two problems. The method which is used to overcome these problems has been listed below.
Proof of Importance Mechanism
The proof of importance mechanism works in the following manner:
- Proof of importance does not only count how many coins are held in the digital wallet but it also counts how long these coins have been held. This system incentivizes people to hold on to the coins in their wallets in the cryptocurrency form. After the coins have been held for a certain predefined amount of time, they are said to be vested. Only vested coins are used to determine the proof of importance score. The number of vested coins is probably the most important factor which is used in order to determine the proof of importance score. A certain minimum number of vested coins are a prerequisite that allows people to harvest more coins. The terminology used here is harvesting as opposed to mining and forging in proof of work and proof of stake respectively.
- Proof of importance also provides a higher score to investors who make regular transactions with others on the network. This is what makes proof of importance more stable and dependable since it incentivizes the free circulation of coins instead of hoarding coins. The algorithm has been built in such a manner that it will be able to detect circular trading amongst a small number of investor accounts. Fake transactions which have been undertaken just for the purpose of increasing the POI score will be detected and weeded out as per the design of the proof of importance mechanism
- Proof of importance transactions also rewards certain types of transactions. For instance, larger transactions are given more importance as compared to smaller transactions. Also, frequent transactions are rewarded more than infrequent transactions. These rules have been created in order to ensure that the use of cryptocurrency increases over time and it becomes a viable substitute to fiat money instead of being used only for speculative activities
- The proof of importance score is a composite score that is derived from several factors some of which have been mentioned above. For instance, the number of vested coins, the number of transaction partners, average transaction size with these partners, and net transactions undertaken in the past 30 days are all taken into account to derive this score.
From the above-mentioned points, it is clear that the proof of importance mechanism does get rid of a lot of problems associated with the proof of stake mechanism. For instance, in this mechanism, the rich no longer get richer and the cryptocurrency actually behaves like a currency i.e. it keeps flowing amongst people instead of being hoarded and locked in digital wallets. Hence, it can be said that even though proof of importance is not a very popular concept today, it may soon be noticed by investors because of its merits and may end up becoming the predominant consensus mechanism in the future.
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The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
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